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Disclosure statement

Jaime Luque does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond the academic appointment above.

Anyone who’s dug into the 2008 financial crisis knows the role that bundling and selling subprime housing loans played in bringing the world to the brink of economic collapse – out-of-control behaviors well-depicted in the movie “The Big Short.”

But one thing I hope “The Big Short” doesn’t do is further tarnish the image of subprime lending.

Despite their poor reputation, such loans remain a key tool in easing the housing affordability crisis and expanding the availability of mortgages to low-income Americans seeking to realize the dream of homeownership. They also can help policymakers cope with the growing ranks of the homeless.

I’ve been studying the world of subprime in recent years, and these are some of the lessons from my current and past research. First, we need to fix the subprime mortgage market, so that the ways in which it contributed to the financial crisis aren’t repeated.

Shocking levels of homelessness

Los Angeles, New York and other cities in America are struggling to cope with the problem of homelessness and the lack of affordable housing.

On a single night in January 2015, more than 560,000 people nationwide were homeless – meaning they slept outside, in an emergency shelter or in a transitional housing program. Almost a quarter were children. Meanwhile, homeownership is hovering at 20-year lows, while about half of renters struggle to pay their landlords.

Last fall, Los Angeles Mayor Eric Carcetti asked the City Council to declare “a state of emergency” on homelessness and committed US$100 million to solving the problem, suggesting that subsidies would play a role.

But a focus on rental subsidies to solve homelessness and other affordable housing issues has adverse consequences, as evidenced by New York’s experience.

Its cluster-site housing program, in which privately owned apartment buildings are used to house homeless families when the city’s shelters are full, relies on such subsidies. But because the city typically pays market rents (or more), many landlords responded by pushing out regular (and low-income) tenants in favor of this steady stream from the government.

Such programs reduce the overall supply of affordable units, crowding out other groups in need. As more affordable housing units are allotted to the homeless, there are fewer available for low-income residents who don’t qualify for those programs and are at risk of becoming homeless themselves.

Fortunately, Mayor Bill de Blasio aims to phase out the costly program over the next three years.

While there are many other approaches to tackling homelessness, they rely on addressing an important underlying problem: the housing affordability crisis. It may seem improbable, but subprime lending could help ease the housing affordability crisis.

The role of subprime lending

The relationship between homelessness and the strains in the housing rental market is well-known: when there are more rental vacancies available, homelessness decreases (I survey the academic findings on the topic here).

This suggests that if we reduce home affordability problems, we can effectively reduce homelessness.

A powerful tool to help ease the housing affordability crisis is subprime mortgage lending – defined as loans made to borrowers with credit scores below 640.

The idea is simple: by helping more low-income tenants qualified to take out a subprime mortgage become homeowners, there’ll be more affordable rental housing available for everyone else. More supply on the market helps reduce average rents, which in turns helps more of those pushed to the streets afford a roof over their heads with less government aid. Thus this makes the policies still based on rental subsidies more effective.

However, this idea cannot be implemented until we fix the subprime mortgage market. As you can see from the graph below, the market has not yet recovered from its collapse in 2008.

The subprime market has yet to recover from its collapse.Inside Mortgage Finance, Author provided

One of the reasons the market collapsed was that investors lost confidence in the ability of loan originators and regulators to use credit scoring models to accurately assess a borrower’s creditworthiness – remember the NINJA loans (no income, no job, no assets)?

This market won’t be back up and running at full strength – and able to help address the affordability crisis – until these credit-scoring models improve and mechanisms are put in place to ensure loan quality remains adequate.

The FHFA sets new goals

There has been some movement to get the subprime market moving again.

The Federal Housing Finance Agency (FHFA), an independent federal agency that regulates Fannie Mae, Freddie Mac and the 12 Federal Home Loan Banks, recently set goals for the next two years meant to expand the availability of mortgages to low-income buyers.

This policy will keep its focus on helping a small segment of borrowers with incomes no greater than 50 percent of their area’s median income to purchase or refinance a single-family home.

But many affordable housing advocates expressed concern that these targets do not go far enough. The Woodstock Institute – a leading research and policy nonprofit organization focused on fair lending, wealth creation and financial systems reform – for example, argued that the policy won’t do enough to promote affordable and sustainable home ownership for low-income families.

How to bring back subprime

Even with the FHFA embracing the idea of expanding the availability of subprime mortgages to low-income buyers, their perceived role in the 2008 crisis and bringing down the housing market may cause justifiable resistance from the general public as a means of tackling the affordability crisis.

And one cannot blame this reaction, as it was the average American taxpayer who bailed out the reckless financial system, brought down by greedy bankers and weak politicians and regulators.

So how we can encourage more subprime lending while avoiding a repeat of 2008? In my recent research, I suggest a few ways to do this.

One of the reasons subprime loans became such a problem in the run-up to the crisis is just the sheer volume (see the boom in subprime lending from 2001 to 2005 in the above graph). This expansion was fueled by the generous homeownership subsidies given to low-income households.

One way to help prevent this is to vary the size of the homeownership subsidy countercyclically to control the amount of credit flowing into the economy and prevent overborrowing during expansionary periods. It would be higher at times when the housing market contracts, and lower when it’s booming.

Another problem was that lenders had an incentive to originate mortgages to borrowers who couldn’t afford them because all the risk was passed along to banks and other investors through collateralized mortgage obligations (CMO) and other sophisticated financial instruments.

The Federal Reserve in conjunction with other regulators could reduce this risk by carefully monitoring how many mortgages lenders keep in their own portfolios. When the share lenders hold increases, they have more incentives to better screen borrowers and thus originate better mortgages.

Lastly, the so-called adverse selection problem on the part of the mortgage originator in the secondary market should also be taken into account. This problem occurs when the mortgage originator has more information about the quality of mortgages that are securitized than the secondary market investors who snap up the CMO. That allows the originator to keep the low-risk mortgages in its own portfolio while distributing the high-risk mortgages to investors.

Improving existing credit scoring models is crucial to ameliorating this problem. Also, the Fed should more carefully monitor the quality of mortgages that are sold to investors and share its information with them. At the very least, that would reduce the investors’ information disadvantage with respect to originators.

Accompanied by the right means to regulate the housing market, we can support subprime while avoiding the disastrous outcomes highlighted in “The Big Short.” And we can create an environment in which making low-cost mortgages available to people helps resolve the problem of unaffordable housing and homelessness.